How to recognize revenue when rights of return are present

2. Example of recognizing revenue at the time of sale

Let’s look at the following example to better understand the accounting for future product returns.

Company AndroidMow (a fictitious company) manufactures robotic lawn mowers. About two years ago the company developed a model of its best-selling product Robo2 XX5. The management estimates (based on prior return experience with this product) that the rate of return for this product will be 10%. The company issues a three-months return policy to its distributors.

In this example the company is able to reasonably estimate the rate of product returns. Assume also that all other criteria for revenue recognition are met.

In January 20X2, the company sold on account 1,000 units of Robo2 XX5 for $1,000,000 (i.e., $1,000 sales price per unit). The associated cost of goods sold was $600,000 (i.e., $600 cost per unit). Based on its estimates of future product returns, the company recorded $100,000 of sales returns (i.e., $1,000,000 x 10% or 1,000 units x $1,000 per unit x 10%). The company also created a valuation allowance for the cost of sales on estimated returns of $60,000 (i.e., $600,000 x 10%). As we can see, net sales were $900,000, while net cost of sales was $540,000.

Net Sales = Sales - Sales Returns and Allowances

Net Sales = $1,000,000 - $100,000 = $900,000


Net Cost of Sales = Cost of Sales - Cost of Sales on Estimated Returns

Net Cost of Sales = $600,000 - 60,000 = $540,000

To record the sale of 1,000 units, the company would make the following journal entries at the time of sale:

Account Titles

Debit

Credit

Accounts Receivable

$1,000,000

 

      Revenue

 

$1,000,000

Account Titles

Debit

Credit

Cost of Goods Sold

$600,000

 

      Inventory

 

$600,000

To record the estimate of 100 (i.e., 1,000 x 10%) product returns, the company would make the following journal entries at the time of sale:

Account Titles

Debit

Credit

Sales Returns and Allowances

$100,000

 

      Accounts Receivable

 

$100,000

Account Titles

Debit

Credit

Inventory – Right of Return

$60,000

 

      Cost of Sales on Estimated Returns

 

$60,000

The right of return on units sold in January 20X2 expired in April 20X2 (i.e., three months as indicated in the company’s policy). During the period from January 20X2 to April 20X2, 95 units of Robo2 XX5 were returned and five (5) units were not returned. The receipts of returned goods were already recorded when the company established the estimates of returned goods at the time of sale (see above). However, five units of the 100 estimated to be returned, were not actually returned. So, the company would make the following journal entry to adjust its original estimate of returned goods (i.e., sales of $5,000 and cost of sales of $3,000):

Account Titles

Debit

Credit

Accounts Receivable

$5,000

 

      Sales Returns and Allowances

 

$5,000

Account Titles

Debit

Credit

Cost of Sales on Estimated Returns

$3,000

 

      Inventory – Right of Return

 

$3,000

These journal entries will close the right of return estimates for units sold in January 20X2. Note that the company also sold units in February, March, etc. and estimates for those will need to be accounted for as well.

Important: There are several ways to account for product returns from the bookkeeping standpoint. We only suggest one approach. Other approaches exist and may be more appropriate. However, the important factor is not the bookkeeping side, but the requirement that for any sales made with a right of return in which the revenue recognition criteria are met revenue and cost of sales reported in the income statement shall be reduced to reflect estimated returns.

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